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CHAPTER 13 Welfare economics ©McGraw-Hill Education, 2014 Welfare economics • The branch of economics dealing with normative issues. • Its purpose is not to describe how the economy works, • but to assess how well it works. ©McGraw-Hill Education, 2014 Equity and efficiency • Horizontal equity – the identical treatment of identical people • Vertical equity – the different treatment of different people in order to reduce the consequences of their innate differences ©McGraw-Hill Education, 2014 Pareto efficiency • An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. ©McGraw-Hill Education, 2014 Perfect competition and Pareto efficiency • If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. • As expressed in Adam Smith’s notion of the invisible hand ©McGraw-Hill Education, 2014 Competitive equilibrium and Pareto-efficiency SS D P1* D • At any output such as Q1*, the last film must yield consumers P1* extra utility. • The supply curve for the competitive film industry (SS) is the marginal cost of films. • Away from P1*, Q1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers so a move to that position makes society better off. Q1* Quantity of films ©McGraw-Hill Education, 2014 Distortions & the theory of the second best • A distortion exists whenever society’s marginal cost of producing a good does not equal society’s marginal benefit from consuming that good. • Some such distortions may be inevitable, and it may be more efficient to spread such distortion over a wide range of markets, rather than concentrating it in one market. • This results from the theory of the second-best. ©McGraw-Hill Education, 2014 Market failure • Market failure occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation. • Imperfect competition • Social priorities (e.g. equity) • Externalities • Other missing markets include those concerned with future goods, risk, information ©McGraw-Hill Education, 2014 Externalities • An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others, other than through market prices – e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers ©McGraw-Hill Education, 2014 A production externality (1) Suppose DD represents the demand curve for a product (which we may interpret as marginal social benefit). D P MPC D Q Quantity ©McGraw-Hill Education, 2014 MPC is the marginal private cost incurred by the firm in producing the good (assumed constant for simplicity). The market clears where MPC = DD at price P and quantity Q. A production externality (2) MSC If the firm causes pollution, it imposes costs on society, presented by marginal social costs (MSC). So the social optimum is where DD(MSB)=MSC at Q*. The overall welfare MPC loss to society from the market failure is DD given by the excess (MSB) of MSC over MPC between Q* and Q. Q* Q Quantity ©McGraw-Hill Education, 2014 A consumption externality E.g. neighbours may benefit from a well-kept garden. Price MPC, MSC MSB DD(MPB) Q Q' Quantity As a consequence of a consumption externality MSB>MPB, and the free market equilibrium provides the quantity Q. As compared with the social optimum at Q', where MSB = MSC. The pink area shows the welfare loss. ©McGraw-Hill Education, 2014 A brief history of global temperatures ©McGraw-Hill Education, 2014 CO2 emissions 1850-2004 ©McGraw-Hill Education, 2014 Annual greenhouse gas emissions per country in 2004 – % of world total ©McGraw-Hill Education, 2014 Kyoto Protocol • Began 1997 • By 2006, 169 countries had signed, (not including the US). • By 2012, emissions will be 5% lower than in 1990. • Various schemes are in place, including carbon trading. ©McGraw-Hill Education, 2014 Is it worth it? • Should China cut back today to make the future better? • The Stern Review concluded that 1% of global GDP must be invested from now on if we are to head off the worst effects of climate change, • and that failure to act now risks a future cost of up to 20% of global GDP. ©McGraw-Hill Education, 2014 Concluding comments (1) • Welfare economics deals with normative issues or value judgements. • Horizontal equity is the equal treatment of equals, and vertical equity the unequal treatment of unequals. A resource allocation is a complete description of what, how and for whom goods are produced. • An allocation is Pareto-efficient if no reallocation of resources would make some people better off without making others worse off. ©McGraw-Hill Education, 2014 Concluding comments (2) • Distortions occur whenever free market equilibrium does not equate marginal social cost and marginal social benefit. • Distortions lead to inefficiency or market failure. • When only one market is distorted the first-best solution is to remove the distortion, thus achieving full efficiency. • The theory of the second-best says that it is more efficient to spread inevitable distortions thinly over many markets than to concentrate their effects in a few markets. ©McGraw-Hill Education, 2014 Concluding comments (3) • Production externalities occur when actions by one producer directly affect the production costs of another producer, as when one firm pollutes another’s water supply. • Consumption externalities mean one person’s decisions affect another consumer’s utility directly, as when a garden gives pleasure to neighbours. ©McGraw-Hill Education, 2014